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Thursday, September 11, 2014

Goldman Declares The "End Of The Iron Age"

Back in the summer of 2008, when crude seemed poised to take out $150, Goldman decided to declare the start of a commodity supercycle and boosted its oil price forecast to $200. Shortly thereafter crude cratered, plunging to the low double digits, and causing many to scratch their heads whether Goldman was merely taking advantage of the pre-Lehman panic to sell into the euphoria. The same questions, but inverted, will likely follow today's just as seminal note, one which this time calls for the end of a supercycle, this time of iron, with "The end of the Iron Age."

While intuitively this makes sense considering iron ore prices have tumbled nearly 40% YTD and were at multi-year lows at last check with the demand picture going from bad to atrocious, the reality is that a protracted period of deflation in this key commodity will have very adverse implications for not only China, where CapEx amounts to over half of GDP and will likely force the transition to a consumer-driven economy - something the Politburo has been delaying for years - but for the rest of the commodity suppliers countries, with the most negative impact hitting Brazil and Australia. Worse, for a country like China which has thrived on commodity oversupply and overcapacity, the collapse in the equilibrium price driven largely by demand, will mean thousands of suppliers will be left out in the cold and forced to liquidate with massive ripple effects through the fabric of the Chinese economy.

To be sure, for the time being local governments, banks and other SOEs, and the central bank, have been successful in isolating the assorted pockets of deflation that has hammered China in the past several years, but if Goldman is correct and if indeed a iron (and other commodities) are shifting from the "Investment Phase" to the "Exploitation Phase" as Goldman calls it, then watch out below not only China, but the rest of the world as well.

So what exactly does Goldman say? Let's dig into their latest note:

The end of the Iron Age

Producers and investors have enjoyed a long period of supply tightness, cost inflation and above trend profitability; in our reports we have referred to this period as the Iron Age. In our view, 2014 is the inflection point where new production capacity finally catches up with demand growth, and profit margins begin their reversion to the historical mean; in other words, the end of the Iron Age is here.

Iron ore has entered a new exploitation phase

As we have previously argued3, a period of overinvestment in production capacity has ended, giving way to an exploitation phase where supply growth comes mainly from more efficient utilization of existing capacity. Production volumes grow with a certain time lag behind the investment decision; the lag in the mining industry between investment approval and production at full capacity is typically between 5 and 10 years. Based on historical trends, we believe that many market dynamics are reversed in the shift from investment to exploitation, and the current exploitation phase in iron ore could last for a decade (Exhibit 20).

On the demand side, lower prices for iron ore and steel are unlikely to boost demand in a material way. Instead, the day when steel production in China will peak gets ever closer. In the past decade, the Chinese economy added steel to its economy at a rate three times faster than the US did during the 20th century. On a per capita basis, the average household in China is accumulating steel at a rate equivalent to the purchase of a new car every 8 months (without disposing of its older cars). In other words, the volume of steel stock in China is racing towards the US level of 13 tonnes per person (Exhibit 21). If China is to converge towards the US level, steel consumption will eventually have to stabilize and steel recycling will play a larger role.

On the supply side, the capital stock of the iron ore industry in Australia, Brazil and China increased by US$180 billion during the period 2003-12; this will fuel production growth for years to come (Exhibit 22). Now that the market has transitioned to an exploitation phase we expect new approvals for capital intensive projects to become increasingly rare, largely because the economics of greenfield projects will be challenging in an oversupplied market. However, projects approved in the later stages of the investment phase will support production growth in the years ahead, and low cost brownfield expansions at Tier 1 producers will remain attractive.

Can prices recover once marginal supply is gone? We don’t think so

In principle, the displacement of marginal producers should eventually lead to a balanced market with a high level of concentration among the top 4 miners, raising the prospect of a price recovery further down the road. In practice, we believe that market fundamentals will continue to see supply growth outpacing demand growth by a ratio of 3 to 1 over our forecast period. Not only is the growth pipeline set to deliver several large projects over our forecast period (Minas Rio, Roy Hill, Serra Sul as well as large expansions at Rio Tinto and BHP Billiton), but the supply side will also have many idled mines waiting on the sidelines and ready to resume production should prices recover.

Moreover, iron ore markets went through a 20-year period of declining prices in real terms during the previous exploitation phase that ended in 2004. The iron ore price in 2003 was the same as in 1983 in nominal terms; this is equivalent to an annual deflation rate of 3% in real terms (Exhibit 23). In our view, iron ore prices will display a similar trend of cost deflation in the current exploitation phase.

Cost curves become flatter via the loss of marginal supply and they shift downwards via rising productivity and weaker commodity currencies. Commodity currencies have started to depreciate relative to the US dollar; the weighted average across five of the largest seaborne exporters has lost 16% since January 2011 (Exhibit 24). Given that a majority of production costs are denominated in local currency, this has a direct impact on the level of marginal production costs. On the productivity front, the increased focus on efficiency and the ramp-up of production has already resulted in a modest decline in unit costs among some producers; we expect this trend to continue.

Many moving parts but China remains the key question

The veil on Chinese iron ore production and the level of cost support it would provide to seaborne prices was supposed to be lifted as the market moved into surplus during 2014. But instead of a clear answer, recent data from China only raise further questions regarding the scale of the supply response low prices. In the seaborne market, the delivery of new projects in Australia and Brazil more than offsets the closure of marginal producers. Meanwhile, slower growth in low grade ore supply should see grade discounts normalise.

Chinese riddle: making sense of production statistics

The Chinese iron ore sector is highly fragmented and the data on supply trends is rather limited, but official statistics on price and volume have been roughly consistent in the past: high domestic prices coincided with growth in raw ore production, while market corrections in 2H 2012 triggered production cuts among marginal miners. On that basis, the recent decline in domestic concentrate prices should have led to another deceleration or even contraction in raw ore volumes. Instead, NBS statistics suggest that volume growth has accelerated (Exhibit 3). We find this highly counterintuitive. First, media reports from Platts and other sources indicate that many small mines stopped production from Q2 2014 onwards. Second, a rising volume of domestic ore would be inconsistent with the reported statistics on steel production and iron ore imports which show high growth in Fe supply but low growth in Fe consumption (Exhibit 4).

What does this all mean? We consider the following hypotheses:

Official statistics do not reflect actual iron ore production. Provincial governments may set GDP or tax revenue targets at the start of the year, and set iron ore production estimates accordingly.

Official statistics only capture some production. The smallest miners may slip through the cracks if they fall below the threshold used in data collection, preventing the closure of small private mines from appearing in official statistics.

Production can cut at the concentrator rather than the mine. Mines may choose to suspend sales to concentrators but continue to operate in order to minimize disruption to their operations.

In our view, a combination of these factors could be responsible for the muddied picture, forcing us to look for alternative ways to assess current trends in Chinese iron ore supply. One option is to calculate the implied production of iron ore from statistics on crude steel production and iron ore imports. Taking into account the changes in iron ore inventory and the modest variations in the grade of imported ore, this analysis suggests that Chinese iron ore production on a 62% Fe basis grew during Q1 (partly reflecting limited disruption from a mild winter) before contracting in the following quarter; implied production in the year to July is down 11% yoy (Exhibits 5 and 6). Importantly, the timing of this contraction coincides neatly with the decline in the price of domestic concentrate in Hebei.

Industry sources also suggest that some Chinese supply has been displaced. The MySteel survey shows that utilization rates began to drop in May 2014 when the domestic price of concentrate was heading towards Rmb900/t, with the smallest mines reporting the lowest rates of utilization (Exhibit 7). Meanwhile, the consensus view at a recent conference on Chinese iron ore was that many private mines had indeed closed, even if the aggregate impact on production was limited due to their small size. However, producers also indicated that efforts to expand domestic production are ongoing, as implied by the volume of investment in the sector (Exhibit 8).

Given this wide range of sometimes conflicting indicators, we assume that future Chinese iron ore production would remain roughly stable before mine closures, as new projects and depletion at existing mines offset each other. We continue to assume that the average grade mined in China will remain stable at c. 20% Fe based on a) the reported grade of new projects and b) the fact that closures are likely to affect mines with below-average grades the most. After factoring in mine closures, we forecast domestic production to decline by c.9% per year on a Fe adjusted basis.

Over our forecast period, we expect input cost inflation to moderate as labour markets loosen and suppliers (from consumables to rail and port operators) see margin compression. The depreciation of key currencies including the A$ and the Brazilian real is likely to continue as weaker commodity prices weigh on the local economy. Finally, just as mining productivity began to improve among metallurgical coal producers during 2013, we now expect a similar type of improvement in the iron ore sector. On balance, we apply a 3% rate of annual deflation in real terms to derive our price forecasts for 2016-17 from our starting point of US$80/t in 2015.